Weak Consulting Stings Accenture, But The Valuation Is Interesting

With weak IT spending in hardware and software, it shouldn't come as a huge surprise that conditions have softened in the service area as well. That's bad news for Accenture (NYSE:ACN), as well as rivals like IBM (NYSE:IBM) and Cognizant (Nasdaq:CTSH), and Accenture is seeing both sluggish bookings in consulting as well as a slower process of converting those bookings into revenue. While current conditions aren't the best, Accenture is a company built to win over the long term, and today's valuation is interesting for investors willing to be patient during this downturn.

Fiscal Q3 Okay, But...
Relative to the sell-side expectations going into the quarter, Accenture did alright by most financial metrics. Even so, the details weren't very positive and this is clearly not a great (or easy) time for the business.

Revenue rose 1% as reported (or 3% in constant currency), with consulting down 2% and outsourcing up 4%. I've seen at least one sell-side analyst call this number “significantly below” expectations, but I'll leave it for readers to decide just how significant a 3% miss relative to the average analyst estimate really is.

While the ratios of these two segments move around a bit over time, consulting at 54% of total revenue is more or less in line with the normal range. By segment, Health and Public Services was the strongest area (up 9%), while Communications/High-Tech and Resources were both down 5%.

Even in a so-so quarter, Accenture's margin and profit performance wasn't bad. Gross margin improved 80 basis points, while operating income rose 8% (and operating margin expanded by over one point). It's worth noting that in a “bad” or “tough” quarter, Accenture still managed to beat operating margin expectations, which I believe speaks to the company's ability to adjust expenses quickly in response to challenging market conditions.

… Guidance And Trends Are Not So Okay
There certainly was some bad news in the guidance and underlying business trends. Management issued guidance for the fiscal fourth quarter that was about 7% below the prior expectation (at the midpoint), and I'd say that is significant. Here again, though was a little bit of silver lining to the cloud, as the reduction in EPS guidance was only 2% - speaking once again to management's margin preservation skills.

The trends in Accenture's business are not looking so great right now. Short-cycle business has turned down pretty significantly, which I would argue points to a challenging second-half environment for tech and IT companies. Still, I'm not sure this is all directly transferable to Accenture's rivals – Accenture saw meaningful weakness in areas like Brazil and Southern Europe, areas where IBM, Cognizant, and Infosys (Nasdaq:INFY) shouldn't be as vulnerable.

It's also worth noting that the book-to-bill ratio came in at 1.15x this quarter, weaker than the prior quarter (1.29x), but better than the year-ago level (1.02x). The bookings were unbalanced, though, as consulting was down 5% (book-to-bill of 1x) and outsourcing was up 37% (B2B of 1.33x). This matters because traditionally consulting bookings translate into revenue faster than outsourcing, meaning Accenture is likely looking at some short-term weakness in revenue. It's also worth noting that the conversion cycle in consulting seems to be lengthening – another development that points to weaker near-term revenue growth potential.

The Bottom Line
I realize that buying into weakness can often be like playing chicken with a train, but I do believe this is just a momentum disruption of an otherwise solid business plan. Accenture is built to win over the long term, and few companies can match their capabilities or customer loyalty.

I'm looking for Accenture to grow its top line and free cash flow by about 4% to 5% a year over the next decade – well below the trailing rates of 9% and 13%. With that growth, a fair value around $86 seems appropriate, and that's an interesting level of undervaluation given the likely post-earnings reaction. While IT and consulting services is a very competitive market, I think this could be a worthwhile stock to consider once the post-earnings/guidance disappointment dies down.